Greasing the Slide

“Death by a thousand cuts.” “Fire-sale liquidation.” “A vortex of selling.” No matter how people described the market collapse that hit a month ago, the message was the same: it felt like there was nowhere to go but down, and it felt like we’d be going there forever. (Given last week’s dip, it still does.) Beginning on September 29th, the U.S. stock market fell on nine of the next ten trading days, plummeting twenty-six per cent; then, after a short, sharp rally, it lost ten per cent more in less than two days. Explanations for the crash often focussed on the hysteria and panic that periodically seem to seize investors. But the madness of crowds wasn’t the whole story. In a healthy market, there are countercyclical forces—mechanisms and institutions that go against the general market trend and encourage diversity of thinking—that make it harder for feedback loops and vicious cycles to take hold. Lately, though, many of these institutions and mechanisms have become procyclical: instead of countering trends, they amplify them.

Take, for instance, the credit rating agencies, which investors rely upon for evaluations of companies’ creditworthiness and general financial well-being. They are supposed to be a kind of early-warning system for investors, evaluating the health of companies in a way that’s insulated from prevailing market trends. Yet many studies have found that rating agencies are more likely to upgrade companies when investors are bullish and downgrade them when investors are bearish. This makes rating changes less useful to investors and also means that they push the market in the direction it’s already going. On October 9th, Standard & Poor’s announced, late in the day, that it was considering downgrading G.M. That helped an already shaky market fall four per cent in the final hour of trading.

Wall Street analysts have also been good at pouring gasoline on a raging fire. Analysts’ ability to take the long view and scrutinize company fundamentals should make them a counterweight whenever investors get too giddy or too gloomy. And sometimes it works that way: last fall, when investors were still relatively optimistic about banks, Oppenheimer’s Meredith Whitney correctly forecast serious trouble for the industry. More often, though, we see what the U.C.L.A. finance professor Bradford Cornell calls “positive feedback between stock price movements and analyst recommendations.” In other words, analysts often end up following the market, rather than leading it. In the case of a sell-off, this tends to make a bad situation worse. Earlier this month, Goldman Sachs downgraded steel companies like AK Steel. A bold call, you might think, except that it came only after AK Steel’s stock had fallen nearly seventy-five per cent in two months.

Rating agencies and Wall Street analysts are always with us. But the most destructive procyclical force in today’s market is relatively new—hedge funds. There’s an irony here: hedge funds have been touted as a great countercyclical force. Because hedge-fund investors, unlike mutual-fund investors, usually can’t pull their money out on a daily basis, the funds were supposed to be able to take a longer-term view and pursue contrarian strategies (like the hedge-fund manager John Paulson’s huge bets against the subprime bubble). Because they can follow myriad investment strategies—selling short as well as going long, trading derivatives, and so on—they were supposed to add diversity to the market. And the growing influence of hedge funds did indeed coincide with a decline in market volatility. A study by the Federal Reserve Bank of Cleveland showed that hedge funds generally made markets more stable.

Unfortunately, what was true of normal markets has turned out to be irrelevant in a crisis. Hedge-fund investors can’t ask for their money back tomorrow, but they commonly can ask for it at the end of any quarter, and after the market’s tumble this summer many of them did just that—to the tune of more than forty billion dollars in September alone, according to one estimate. The funds had to raise cash to meet those redemptions, which led them to dump stocks seemingly without regard to price. This colossal liquidation led stocks with a high percentage of hedge-fund ownership to fall, in some cases, forty or fifty per cent in a matter of weeks. The problem was magnified by the fact that the funds inevitably piggyback on one another’s trades, which made the selling feed on itself. And the faster funds’ positions shrank the more shares they had to sell in order to raise cash. The process was made still more destructive by many hedge funds’ reliance on leverage—funds often make bets totalling four or five times their capital. On the way up, leverage is great for maximizing returns. On the way down, it’s great at maximizing pain.

The great paradox of the sell-off, then, is that the factors that were supposed to increase the flow of information to investors, foster long-term thinking, and encourage contrarian positions did exactly the opposite. If there’s a silver lining in all this, it’s that investors who can endure past the present moment now have the chance to buy what at least look like very cheap stocks. Still, it’s not surprising that investors have been unwilling to step up. It’s hard enough to catch a falling knife. But it’s nearly impossible when hedge funds are hurling it. ♦